WARNING: CONTAINS MATHS
A call is a type of forward in which the purchaser (also the buyer, the party whom is long, the party who owns a long position) has the right, but not the obligation, to purchase an asset for a predetermined price at a predetermined date in the future. Buying a call is essentially buying a long forward which you have the right (or option) to not execute the contract upon maturity. The agreed upon price is referred to as the strike price which is always priced at the time at which the call is purchased. In essence: a call is a bet that the underlying asset will increase in price by the maturity date of the forward, allowing the buyer to purchase the asset at the strike price and then immediately sell at the spot price for a measurable profit.
t = time, generally noted in years, or fractions thereof
X = the strike price, agreed upon at t=0
C = the price of the call, reflecting the premium due to secure the right to cancel the contract
Q = Quantity of asset to be delivered at t=T, agreed to at t=0
St = Price of the asset at t=t
e = The natural number, e
r = The interest rate for the contract period specified at t=0
max = the mathematical function by which the greatest of presented arguments (separated by commas) is selected
| Future Position |
Payoff |
Profit |
| Long |
max(0,(St - X)) * Q |
{ max(0,(St - X)) * Q } - { C * (1 + r ) * Q } |
| Short |
- { max(0,(St - X)) * Q } |
{ C * (1 + r ) * Q } - { max(0,(St - X)) * Q } |
The table of payoffs and profits illustrates how the buyer, or long position, has the option of executing the call and will do so only if the spot price of the underlying asset is greater than the strike price. If this is true, the buyer wins the bet, and the seller (the writer, the owner of the short position, the party whom is short) loses. Options are a zero-sum game. In truth, the wager of a call is somewhat mitigated by the premium reflected in the price of the call, but this only decreases the gain/loss of the two parties and does not affect the zero-sum nature of the transaction.
Graphically...
P/O ($)
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| ¦ /
| ¦ /
| ¦ /
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+-----------¦/--------- St
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THE PAYOFF OF A LONG CALL
∏ ($)
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| ¦ /
| ¦ /
| ¦ /
+-----------¦--/----------- St
| ¦ /
| ¦/
|-----------¦
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THE PROFIT OF A LONG CALL
P/O ($)
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| ¦
| ¦
| ¦
| ¦
+-----------¦\--------- St
| ¦ \
| ¦ \
| ¦ \
| ¦ \
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THE PAYOFF OF A SHORT CALL
∏ ($)
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| ¦
| ¦
|-----------¦\
| ¦ \
+-----------¦--\--------- St
| ¦ \
| ¦ \
| ¦ \
| ¦ \
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THE PROFIT OF A SHORT CALL
The final piece to the call puzzle lies in the valuation of the premium to be charged by the writer of the call. Generally the price of the call C will be increased by two factors: the increasing duration of the call, and the decreasing delta between the initial asset price and the agreed upon strike price. There are also premium factors which consider the type of call you intend to purchase. A European style call may only be executed or cancelled on its maturity date, whereas an American style call may be executed on any day between the contract date and maturity date. Since it is more likely that the spot price could exceed the strike price over a range of dates, when compared to one specific date, the premium on an American call must always exceed that of a similarly struck European call. Luckily, there are also two formulae of rather advanced arithmatic which can help solve the valuation of a call. Because calls abide by Put-Call Parity, we are able to solve for the price of the premium C just as soon as we have accounted for a "basis of time" in our calculations.
McDonald, Robert L. "Derivatives Markets". 2006. Pearson Education, Inc.